Making Sense of the “Ethics” of Litigation Finance

June 25, 2019

Imagine you are a lawyer and a small business owner seeks your representation. She has a strong breach of contract claim against a supplier—but she doesn’t have the money to pay your legal fees. Fortunately, she says a commercial litigation funder is willing to pay your fees in exchange for a portion of her company’s case proceeds.

Is it ethical for you to work with the client and her funder?

As litigation finance enters the mainstream, lawyers are increasingly faced with this question. But the inquiry may seem daunting in light of the many topics often grouped under the banner of litigation finance “ethics”: Champerty. Privilege. Control. Confidentiality. Fee sharing. The list can go on.

Seeing this catalogue might deter lawyers and claimholders from embracing a relatively new but beneficial way to advance meritorious legal claims. Just as problematic, by lumping the issues together in this undifferentiated way, we may cloud the study of litigation finance by academics, bar committees, and judges who study and regulate the legal profession.

One way to address this problem is to recognize that the principal issues grouped under the banner of litigation finance “ethics” in fact address two quite distinct questions.

First, there are gating questions, which address whether litigation finance agreements are permitted in a particular jurisdiction. Champerty, usury, and fee sharing concerns are all important gating questions.

Second, there are process questions, which address how lawyers and claimholders should engage with funders. Questions regarding confidentiality, control of litigation, and disclosure of funding agreements are important process questions.

Simplifying the inquiry in this way should help us see that the ethical and legal obstacles to litigation finance are less daunting than they may initially appear. The gating questions should not preclude standard commercial funding agreements in most jurisdictions. And the process questions address issues, such as maintaining client confidences, that lawyers have successfully navigated since long before the dawn of litigation finance, and should be able to manage in the context of litigation finance too.

One set of “ethics” questions concern whether funding is allowed in a particular jurisdiction. The most common gating questions concern champerty, usury, and the prohibition on fee sharing between lawyers and non-lawyers.

Champerty. The ancient doctrine of champerty prohibits what Blackstone called “officious intermeddling in a suit that no way belongs to one, by maintaining or assisting either party, with money or otherwise,” in return for a portion of case proceeds. 4 W. Blackstone, Commentaries *134–36. See also In re Primus, 436 U.S. 412, 424 n.15 (1978). Although champerty and the related doctrine of maintenance are sometimes discussed as questions of litigation finance “ethics,” they are matters of state statutory or common law.

“The consistent trend across the country,” a federal appeals court has recognized, “is toward limiting, not expanding, champerty’s reach.” Del Webb Communities, Inc. v. Partington, 652 F.3d 1145, 1156 (9th Cir. 2011). Champerty is on the decline principally because of a growing belief that the doctrine is no longer necessary to cure the perceived evils it was devised to combat. Ethics rules more directly prohibit lawyers from filing frivolous claims or allowing third parties to control litigation. Moreover, “[w]e have long abandoned the view that litigation is suspect,” Massachusetts’ high court explained when abolishing champerty in that state, and indeed “agreements to purchase an interest in an action may actually foster resolution of a dispute.” Saladini v. Righellis, 687 N.E.2d 1224, 1226 (Mass. 1997).

Before entering into funding agreements, claimholders and lawyers should certainly consider the relevant state’s champerty laws. In most jurisdictions, however, champerty should not leave impecunious litigants locked outside the courthouse gates.

Usury. Lawyers and their clients sometimes ask whether litigation finance agreements violate usury laws. As with champerty, this gating question should not prohibit standard commercial funding agreements in most jurisdictions.

Most decisions hold that litigation finance agreements are not loans subject to usury laws. As a New York court has explained, standard funding agreements “are not loans, because the repayment of principal is entirely contingent on the success of the underlying lawsuit.” Cash4Cases, Inc. v. Brunetti, 167 A.D.3d 448, 449 (N.Y. App. Div. 2018). Other courts have similarly concluded that the usury laws do not apply because the funded party does not have an absolute obligation to repay the investment, and because the funder’s return is limited to a portion of case proceeds. See Ruth v. Cherokee Funding, LLC, 820 S.E.2d 704, 710 (Ga. 2018); Anglo-Dutch Petroleum Int’l, Inc. v. Haskell, 193 S.W.3d 87, 96 (Tex. Ct. App. 2006).

Notably, finance agreements’ “non-recourse” nature is part of what makes them so appealing. If you take out a traditional bank loan to fund litigation and then default on that loan, the bank might take your home, office, or car. Not so with litigation finance: if you lose your case, the funder receives nothing. Funders succeed only if the case succeeds.

Fee Sharing. The ABA’s Model Rule of Professional Conduct 5.4(a) and state analogues generally prohibit lawyers from “shar[ing] legal fees with a nonlawyer.” Rule 5.4 presents a gating question because lawyers may not enter into agreements that violate the professional ethics rules.

Most funding agreements do not implicate the rule against fee sharing for the simple reason that most funding agreements are between the funder and the claimholder, not the claimholder’s lawyer. In this common scenario, the funder may pay the lawyer’s legal fees on behalf of the client, but the lawyer does not share its fees with the funder. Instead, the funder’s return is paid out of the claimholder’s share of case proceeds.

A more contested question is whether funders may contract directly with law firms and receive a return from the firm’s contingent interest in one or more cases. Model Rule 5.4 is titled “Professional Independence of a Lawyer,” and the comments to the rule make clear that the prohibition against fee sharing exists “to protect the lawyer’s professional independence of judgment.” The prevailing view among practitioners is that, at least where the funder’s return is backed by three or more cases, the rule against fee sharing is not implicated because the funder’s return is not traced to any particular case and the lawyer’s exercise of professional judgment is not impaired.

Notably, the ethics rules already allow lawyers to work on a contingency fee (Rule 1.5(c)), and they permit someone other than the claimholder to pay a lawyer’s legal fee (Rule 1.8(f)). In these circumstances, the Rules address any threat to a lawyer’s professional independence by insisting that the lawyer maintain her professional independence and that the claimholder maintain control over the litigation. There is, however, some disagreement about whether funders may contract directly with law firms, including from a nonbinding 2018 opinion of the New York City Bar, which concluded that lawyers may not enter into financing agreements with funders where the lawyer’s payments to the funder are contingent on the lawyer’s receipt of legal fees.

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The most important gating questions concern champerty, usury, and fee sharing. So long as a funding agreement does not violate these prohibitions, the gates should be open, and parties should be allowed to enter into litigation finance agreements. As you might guess by the rapid growth of litigation finance over the past decade, gating questions should not prohibit standard commercial litigation finance in most U.S. jurisdictions.

Process Questions: How should lawyers and claimholders engage with funders?

Distinct from these gating questions are process questions, which address how lawyers and claimholders should engage with funders, courts, and other parties. These process questions do not concern the legality of funding agreements as such; rather, they concern the code of conduct for funded parties and their lawyers. As with the gating questions, some of these questions concern legal ethics, but others concern state law.

These process questions concern issues like privilege, control, and disclosure that are nothing new. Lawyers think about and successfully navigate these issues every day, and it is possible to navigate these issues in the context of litigation finance too.

Privilege and Confidentiality. Whenever lawyers interact with someone other than the claimholder—whether it be an expert witness, a litigation funder, or anyone else—they must be careful to maintain privilege and confidentiality. The sources of law that are relevant to this issue are familiar to attorneys.

For example, ABA Model Rule 1.6(a) and state analogues requires a lawyer to obtain a client’s consent before sharing confidential information with third parties. Thus lawyers should secure client consent before sharing confidential information with funders, the same way they would before sharing that information with any other non-client.

Two other well-known doctrines—the attorney-client privilege and the work product doctrine—are also relevant. Reputable funders do not request attorney-client communications. Funders may, however, receive work product under the proper circumstances.

The work product doctrine generally protects from discovery “documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative ….” Fed. R. Civ. P. 26(b)(3)(A). Lawyers and claimholders often provide work product to funders to assist the funder in evaluating the case. The overwhelming majority of decisions hold that because the documents and communications with funders are made in anticipation of litigation, the materials are shielded from discovery under the work product doctrine. See, e.g., Lambeth Magnetic Structures, LLC v. Seagate Tech. (US) Holdings, Inc., 2018 WL 466045, at *5 (W.D. Pa. Jan. 18, 2018); United States v. Homeward Residential, Inc., 2016 WL 1031154, at *6 (E.D. Tex. Mar. 15, 2016). Parties that seek funding should also enter into non-disclosure agreements with a funder to help prevent any waiver of work product protections. Miller UK Ltd. v. Caterpillar, Inc., 17 F. Supp. 3d 711, 738 (N.D. Ill. 2014).

Lawyers and claimholders should be mindful of privilege and confidentiality issues when they interact with funders. But most decisions recognize that parties may obtain the funding necessary to bring their claims without sacrificing privilege or confidentiality.

Control. Another question often discussed under the topic of the “ethics” of litigation finance is whether funders may control litigation strategy and settlement decisions. A variety of ethics rules require that the claimholder and lawyer—not any third party—must control litigation strategy. For example, Model Rule 1.2(a) provides that “[a] lawyer shall abide by a client’s decisions concerning the objectives of representation” as well as “a client’s decision whether to settle a matter.” Model Rule 2.1 requires that a lawyer “exercise independent professional judgment” on behalf of a client. And Model Rule 1.8(f) permits a third-party to pay a lawyer’s fee only if “there is no interference with the lawyer’s independence of professional judgment or with the client-lawyer relationship.”

Together the ethics rules prohibit funders from controlling litigation strategy or settlement negotiations. Reputable funders scrupulously adhere to this requirement. But as with the disclosure requirements just discussed, this issue is nothing new. Every day, lawyers must ensure that their clients—not third-parties—direct the litigation. And just as attorneys are skilled in putting their clients first even in the face of theoretical conflicts of interest when the lawyer works on a contingent fee or a third party pays the lawyer’s legal fees, so too are lawyers perfectly capable of putting their clients first when funding is involved.

Disclosure. Another issue sometimes discussed under the banner of “ethics” concerns whether lawyers must disclose their funding relationship to the court and an opposing party. This, too, is properly understood as a process question, for it involves how parties should act when they receive funding, not whether litigation finance agreements are lawful.

The disclosure issue comes up in two principal contexts. First, during discovery, litigants sometimes request documents related to any litigation finance agreement that their adversary may have entered into. The discovery rules allow courts to require disclosure of “any nonprivileged matter that is relevant to any party’s claim or defense and proportional to the needs of the case,” Fed. R. Civ. P. 26(b)(1), but most decisions hold that funding documents do not need to be disclosed because they are irrelevant to the merits of a case. See, e.g., Benitez v. Lopez, 2019 WL 1578167, at *1 (E.D.N.Y. 2019); Kaplan v. S.A.C. Capital Advisors, L.P., 2015 WL 5730101, at *5 (S.D.N.Y. Sept. 10, 2015). Compare Gbarabe v. Chevron Corp., 2016 WL 4154849, at *2 (N.D. Cal. Aug. 5, 2016) (holding that counsel’s funding was relevant under the particular facts of one class action where the adequacy of representation was at issue).

Second, some opponents of litigation finance have pushed for mandatory disclosure of funding agreements, thus seeking to require disclosure even where funding is irrelevant to case merits. Funders and funded parties typically oppose such disclosures, cognizant that disclosure of the fact and amount of funding provide an asymmetric strategic advantage to the defendant, letting them know which litigants do (and do not) have funding, as well as how much funding is available to funded parties. For the most part, state laws and court rules do not require mandatory disclosure of funding agreements, though lawyers should check the applicable law in each jurisdiction.

Here, too, complying with discovery and disclosure requirements is something lawyers do all the time. While lawyers should be aware of this issue, litigation finance does not present unique problems to litigants and their counsel. And questions about disclosure do not imply the illegality of litigation finance agreements—they simply guide the process by which lawyers and claimholders must interact with opposing parties and the court.

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My suggestion here is that when discussions of litigation finance “ethics” group together a hodge-podge of disparate issues, we may inadvertently make the ethics and legality of funding appear more daunting than they actually are, and we may cloud the study of litigation finance too. A better way to tackle the issues may be to carefully differentiate between gating questions and process questions.

While the analysis I have provided does not purport to comprehensively analyze every legal or ethical issue related to litigation finance, it does lend to two key takeaways. First, as evidenced by the strong growth in litigation finance over the past decade, gating issues such as champerty, usury, and fee sharing concerns should not present a serious challenge to the legality of standard commercial litigation finance agreements in most jurisdictions. Second, while lawyers should be carefully attuned to process questions, including those related to confidentiality, control, and disclosure, these questions are not only manageable but present the sorts of issues that lawyers successfully navigate each and every day.

William C. Marra is a portfolio counsel at Validity Finance. He may be reached at will.marra@validity-finance.com.